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MiFID II - will commodity position limits affect liquidity?

Steven Maijoor, Chair of the European Securities and Markets Authority (ESMA), has recently commented that “the EU is going into new, unchartered territory by implementing the most extensive position limits regime in the world.” The critical issue is whether they will work.

Position limits are intended to prevent market abuse and to ensure convergence between the price of a commodity derivative in the delivery month and spot prices for the underlying commodity. In December 2014, ESMA published draft regulatory technical standards (“draft RTS”) on how it proposes to implement position limits.

Position limits

Member States are obliged to ensure that their national authorities establish and apply position limits on the size of a net position, which a person can hold in commodity derivatives traded on trading venues and economically equivalent OTC contracts. The limits apply to all “persons” and will be set on all positions a trader holds, or are held on its behalf at aggregate group level. Under the draft RTS, ESMA has proposed that an OTC commodity derivative would be “economically equivalent” to a traded contract when it:

Explicitly refers to/is otherwise based upon a commodity derivative traded on an EU trading venue

Is valued on the basis of the same or an equivalent commodity of the same or equivalent grade that is deliverable at the same location, or another equivalent location so long as the other delivery location has similar economic characteristics and is deliverable on the same date as that of a commodity derivative that is traded on a trading venue.

Fortunately ESMA is required to publish a list of these contracts as it is unclear how this will work in practice.

Limits will not apply to non-financial counterparties who use commodity derivatives for hedging (using the EMIR definition).

The methodology

ESMA has the herculean task of proposing a methodology to determine position limits for the spot month and other months’ position limits for physically settled and cash settled derivatives. ESMA acknowledges that it “has to bring a number of contradictory elements together” and therefore needs to be flexible in setting the limits, particularly for new products and for illiquid markets. It will, for example, be relevant to look at whether a commodity is perishable, how it is transported and delivered, whether there are capacity constraints at delivery points and whether the product is seasonal.

ESMA has proposed that the starting point be a position limit that imposes a baseline limit of 25% of “deliverable supply”. Under the draft RTS ESMA proposes how the baseline figure for “deliverable supply” in each commodity derivative should be calculated. It is unclear whether “deliverable supply” is to be interpreted as:

The supply used for settlement;

A pricing reference for the traded commodity derivative; or

The “deliverable supply” in the underlying physical commodity

If this baseline figure is incorrect, there is a real risk that position limits will be set too low. ESMA has proposed that the baseline could be adjusted by +/-15% up to 40%, or down to 10% depending on a range of factors. This has caused some debate in the market and at a recent scrutiny hearing on MiFID II, the Chair of ESMA confirmed that position limits would be applied ‘in a dynamic manner’ and will be lowered or raised in accordance with the position of the relevant spot market.

Factors relevant to increasing or reducing the limits include:

Maturity of the commodity derivative contract

Deliverable supply in the underlying commodity

Overall open interest in commodity derivatives and in other financial instruments with the same underlying commodity

Volatility of the market in the commodity derivatives

Number and size of the market participants that hold a position

Characteristics of the underlying commodity market

Whether a new contract is being developed

Position management controlsand position reporting

The trading limits set by ESMA and the national regulatory authorities do not operate in a vacuum. They are part of a two tier structure. Investment firms, and market operators operating trading venues which trade commodity derivatives, are both required to apply position management controls. They also have an obligation to report commodity derivatives and emissions allowances positions. Any position limits set by a trading venue will need to be equal to, or below, the limits set by the relevant national authority.

Conclusion

The trading community has raised serious concerns about the position limits regime and position reporting obligations. They will certainly make life difficult for investment firms and banks who have traditionally been liquidity providers. It will also be more complicated for producers and end users who want to hedge price risk, which, as recent volatility in the oil market has shown, is a real threat to business.